Chapter 11-Behaviour of the markets

Question 1

1. Explain how the risk vs return impacts a particular asset class over the short and long term.

Answer 1

At the highest level, asset classes with the greatest risk also have the potential for the greatest return over the long term. However, price fluctuations can depress values in the short term.

Question 2

2. What is the main way the government can finance the fiscal deficit and explain how this is achieved?

Answer 2

Issuing government bonds is the main way governments finance the fiscal deficit. The demands of purchasers can influence the terms on which debt is issued.

Question 3

3. What four risks do corporate bonds expose investors to?

Answer 3

Corporate bonds expose investors to default, inflation, marketability and liquidity risk.

Question 4

4. Describe how these risks are allowed for in the price.

Answer 4

The premiums for accepting these risks are factored into the market price of the bonds - in particular the spread, which is the difference between the yield on a corporate bond compared with the equivalent government bond.

Question 5

5. Outline how the corporate bond market can help financial product providers match their asset and liabilities.

Answer 5

Financial product providers who need to match asset proceeds to a stream of benefit outgo can structure a portfolio of bonds so that the assets can all be held to maturity.

Question 6

6. Give an example of contagion risk in relation to equity markets.

Answer 6

For example, an event in the USA that causes US equity markets to fall is very likely to trigger immediate falls in other worldwide equity markets. This is despite the triggering event having no direct impact in other countries.

Question 7

7. Outline a regulatory requirement for financial product providers who offer guarantees.

Answer 7

Financial products generally offer guarantees and to ensure customers are not disadvantaged, regulators require providers to hold capital against guarantees. If product guarantees are covered by guaranteed returns from assets held, the amount of capital earmarked against the product guarantees is reduced.

Question 8

8. Discuss the extent to which a product provider chooses to match its assets to its guarantees.

Answer 8

The extent to which a product provider chooses to match its assets to its product guarantees or to depart from a matched position in the hope of achieving better returns and higher profits will depend on the provider’s risk appetite - which in turn is driven by the free capital it has available.

Question 9

9. What determines the level of prices for an asset class?

Answer 9

The general level of all markets is determined by the interaction of buyers and sellers. As demand for an asset type rises, then the general level of the market in that asset type will rise. If demand falls, then prices will fall. Demand for most investments is very price elastic because of the existence of close substitutes. The main factor affecting demand is investors’ expectations for the level and riskiness of returns on an asset type.

Question 10

10. What are the main factors affecting short-term interest rates?

Answer 10

Short-term interest rates are largely controlled by the government through the central bank’s intervention in the money market. The government sets interest rates, directly or indirectly, in an attempt to meet its (often conflicting) policy objectives.

Question 11

11. Describe the economic effects of low short-term interest rates.

Answer 11

Low real interest rates encourage investment spending by firms and increase the level of consumer spending. So cutting interest rates increases the rate of growth in the short term.
If interest rates in one country are low, relative to other countries, international investors will be less inclined to deposit money in that country. This decreases demand for the domestic currency and tends to decrease the exchange rate.

Question 12

12. Explain how quantitative easing works.

Answer 12

QE works as follows:
* The central bank creates money electronically and uses it to buy assets, usually government bonds, from the market.
* This purchase of assets directly increases the supply of money in the financial system, which encourages banks to lend more and can push interest rates lower.
* The purchase of assets can also reduce the returns on money market assets and bonds, reducing the appeal of those asset types.
Lower interest rates also reduce the cost of borrowing for businesses and households. If businesses use the money to invest and consumers spend more, this can boost the economy.
Stock markets therefore typically respond to news of quantitative easing, with stock markets tending to rise when the central bank announces increased quantitative easing and fall when the central bank announces a contraction in quantitative easing.

Question 13

13. Outline the concept behind the ‘quantity theory of money’ and how this is used to manage inflation.

Answer 13

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services in that economy. According to this theory, if the amount of money in an economy were to double, then price levels would also double, causing inflation. A consumer would have to pay twice as much for the same good or service.

Question 14

14. Describe the following theories used to explain the shape of the yield curve:
    (1) Expectations theory
    (2) Liquidity preference theory
    (3) Inflation risk premium theory
    (4) Market segmentation theory

Answer 14

(1) Expectations theory
Expectations theory describes the shape of the yield curve as being determined by economic factors, which drive the market’s expectations for future short-term interest rates.
If we expect future short-term interest rates to fall (rise), then we would expect gross redemption yields to fall (rise) and the yield curve to slope downwards (upwards).
(2) Liquidity preference theory
The liquidity preference theory is based on the generally accepted belief that investors prefer liquid assets to illiquid ones. Investors require a greater return to encourage them to commit funds for a longer period. Long-dated stocks are less liquid than short-dated stocks, so yields should be higher for long-dated stocks.
According to liquidity preference theory, the yield curve should have a slope greater than that predicted by the pure expectations theory.
(3) Inflation risk premium theory
Under the inflation risk premium theory the yield curve will tend to slope upwards because investors need a higher yield to compensate them for holding longer-dated stocks which are more vulnerable to inflation risk than shorter-dated stocks.
(4) Market segmentation theory
Market segmentation (or preferred habitat) theory says that yields at each term to redemption are determined by supply and demand from investors with liabilities of that term.
Demand for short bonds comes from banks, which compare their yields with short-term interest rate. Demand for long bonds comes from pension funds and life assurance companies that have long-term liabilities.
The supply of bonds of different terms will reflect the needs of borrowers. For example the government may issue short-term bonds if it has a short-term need for cashflow.
The two areas of the bond market may move independently.

Question 15

15. What is the real yield curve?

Answer 15

This is the curve of real yields on index-linked bonds against term to maturity.

Question 16

16. What factors influence the shape of the real yield curve?

Answer 16

The real yield curve, like the conventional yield curve, is determined by the forces of supply and demand at each maturity duration. Thus, it can be viewed as being determined by investors’ views on future real yields modified according to market segmentation theory and liquidity preference theory. The government’s funding policy will also influence the shape of the curve.

Question 17

17. Describe factors that affect the level of bond yields

Answer 17

• Inflation expectations: Inflation erodes the real value of income and capital payments on fixed coupon bonds. Expectations of a higher rate of inflation are likely to lead to higher bond yields and vice versa.
  
  • Inflation uncertainty: Additionally, uncertainty about the level of future inflation will affect conventional bond yields. The higher the uncertainty, the higher the inflation risk premium.
  • Short-term interest rates: The yields on short-term bonds are closely related to returns on money market instruments so a reduction in short-term interest rates will almost certainly boost prices of short bonds. However, investors in long bonds may interpret a cut in interest rates as a sign of monetary easing, with potentially inflationary consequences over the longer term. So the yield on long bonds might decline by a smaller amount, or even rise.
  • Fiscal deficit: If the government’s fiscal deficit is funded by borrowing, the greater supply of bonds is likely to put upward pressure on bond yields, especially at the durations in which the government is concentrating most of its funding. Selling Treasury bills would increase short-term interest rates, while printing money will lower rates but increase expectations of inflation.
  • Exchange rate: A significant part of the demand for government bonds in many markets comes from overseas. Changes in expectations of future movements in the exchange rate will affect the demand from overseas investors. It will also alter the relative attractiveness of domestic and overseas bonds for local investors.
  • Institutional cashflow: The demand for bonds can be affected by institutional cashflow. If institutions have an inflow of funds because of increased levels of savings they are likely to increase their demand for bonds. Changes in regulation and investment philosophy can also affect institutional demand for bonds.
  • Other economic factors: Almost any piece of economic news has implications for inflation and short-term interest rates. The impact of other economic factors can therefore usually be understood in terms of these two quantities.
  • Returns on alternative investments

Question 18

18. What factors affect the yields on corporate bonds relative to those on government bonds?

Answer 18

Economic factors which adversely affect prospects for corporate profitability are likely to increase the perceived risk of corporate bonds relative to government bonds. This will increase the general level of the yield margin of corporate over government debt.

Question 19

19. Explain how the availability and price of government debt might affect the actions of otherwise risk-averse investors.

Answer 19

For example, if government debt was offering very poor returns compared with high quality corporate debt, some investors may weaken their normal risk profile to secure the extra return. This would tend to narrow the gap between corporate and government debt.

Question 20

20. Explain how supply side issues may influence corporate debt yields.

Answer 20

Supply side issues also have an impact. If equity market conditions are depressed, companies may find it easier to raise funds through issues of corporate debt than through equity issues. Oversupply of corporate debt reduces prices and increases yields.

Question 21

21. What factors affect the level of the equity market?

Answer 21

It is investors’ expectations of future corporate profitability and the value of those profits which largely determines the general level of the equity market. Amongst the main factors that influence the general level of the equity market are:
* expectations of real interest rates and inflation
* investors’ perceptions of the riskiness of equity investment
* the real level of economic growth in the economy.
In addition to the factors listed above, any factor affecting supply (eg the number of rights issues, share buy-backs, or privatisations) and any factor affecting demand (eg changes to tax rules, institutional flow of funds, and the attractiveness of alternative investments) will affect market prices.

Question 22

22. Describe the influence of short-term interest rates and inflation on the equity and bond market.

Answer 22

Equity markets should be reasonably indifferent towards high nominal interest rates and high inflation. If the rate of inflation is high, the rate of dividend growth would be expected to increase in line with the return demanded by investors.
It might be argued that high interest rates and high inflation are unfavourable for strong economic growth, so fears of inflation will have a depressing effect on equity prices.
Real interest rates are probably more important than nominal interest rates. Investors expecting high inflation may also expect the government to increase nominal interest rates in response.
Low real interest rates should help to stimulate economic activity, increase the level of corporate profitability, and hence raise the general level of the equity market. Also, the rate of return required by investors should be lower, so the present value of the future dividends will be higher.
Uncertainty about future inflation would make investors more nervous about fixed-interest bonds. Nervousness in the bond market might result in an increase in equity investment, as equities should provide a hedge against inflation. This would tend to increase the relative level of the equity market at the expense of the bond market.

Question 23

23. Describe the equity risk premium.

Answer 23

The equity risk premium is the additional return that investors require from equity investment to compensate for the risks relative to risk-free rates of return.
The equity risk premium fluctuates from time to time, depending on the overall level of confidence of investors and their views on risk.

Question 24

24. Describe the link between real economic growth and the level of the equity market.

Answer 24

In general, real dividends, and therefore the fundamental value of companies, would be expected to grow roughly in line with real economic growth. Therefore changes in investors’ views on economic growth have a major effect on the level of the equity market.

Question 25

25. How will currency movements affect the equity market?

Answer 25

A weaker domestic currency makes exports more competitive, so profits of companies that export goods and services should increase. Profits earned in other currencies are more valuable when converted into the domestic currency.
A weaker currency makes imports more expensive. This reduces corporate profits if firms cannot pass the higher costs of imported raw materials through to consumers. Higher costs of raw materials also lead to inflation. However, if manufactured imports are more expensive, the market share of domestic producers of the same goods should increase.
In countries, like the UK, where a high proportion of profits are earned abroad, sterling depreciation should raise the general level of the equity market.

Question 26

26. Describe the three main areas in which economic influences have an impact on the property market.

Answer 26

• occupation market: the demand for property for occupation, eg businesses seeking commercial property to rent
  
  • development cycles: the supply of newly completed property developments
  • investment markets: supply and demand for properties as investments
    The interaction between occupational demand and the supply of property for rent determines the market level of rents. The capital value of rented property is determined by the investment market.

Question 27

27. Describe how economic factors can influence the occupational demand for properties.

Answer 27

Economic growth
Tenant demand is closely linked to the buoyancy of trading conditions and GDP. Other things being equal, economic growth increases demand for commercial and industrial premises. However, the impact of economic growth will not necessarily be uniform across the different property sectors or throughout all regions of a country.
Any factor that affects economic activity, such as real interest rates, will affect occupational demand for property. For example, levels of employment in the service sector tend to influence occupier demand for offices significantly.

Structural changes
New patterns of economic activity, domestically and globally, change demand patterns. An example would be a trend for firms to move staff out of expensive capital city locations to cheaper areas.

Question 28

28. Explain what factors affect the supply of property over the business cycle.

Answer 28

Property is fixed in location and takes time to develop. Markets can be viewed in terms of the existing stock plus forecast additions to stock. But there are supply side lags and these can be difficult to forecast. The development pipeline can be up to 5 years long. This can result in surpluses of available property when the economic cycle is in a downturn, and shortages as the economy improves.
Property use may be subject to statutory control. Local planning authorities may frequently restrict development.

Question 29

29. Describe the main economic and other influences on the investment market for property.

Answer 29

The property investment market is the market for the sale or purchase of properties for investment (rather than for occupation).
Economic factors influence:
* the investment market for property by altering either the demand for, or supply of properties for sale on the market
* the level of rents in the occupancy market. For example, higher inflation and higher economic activity will increase rents hence increase the capital values of property.

Other factors will influence the property investment market directly:
* An increase in real interest rates should increase the rate of return required by investors leading to a lower present value of a given stream of rents.
* Increasing uncertainty about inflation may increase demand for property investment (a real asset) as a hedge against inflation.
* An expectation of a long-term strengthening of the domestic currency might encourage demand from overseas investors.
* Strong (institutional) cashflows, ie into life offices and pension funds, could increase these institutions’ demand for property.
* The relative attractiveness of other asset classes will also affect the demand for property.

Question 30

30.What factors entirely drive residential property values?

Answer 30

Residential property values are entirely driven by supply and demand.

Question 31

31. Outline how the State can influence supply of residential property.

Answer 31

The State can influence supply by constraints on new development in high demand areas. This can be done through planning restrictions or zonal prohibitions around major cities.

Question 32

32. What factor restricts the demand for residential property?

Answer 32

High house prices compared to earnings levels restrict the number of individuals who can access adequate mortgage funds to make a purchase even at low interest rates.

Question 33

33. Outline how rental demand can impact the value of residential property.

Answer 33

In theory, this constraint on demand should cause prices to fall. However, if interest rates are low, there is an alternative demand from investors to buy residential property and rent it out. The continuing demand for places to live drives up rental levels. Rents are substantially more than can be earned on fixed-interest investments and rental income is relatively secure in times of high demand. If there are sufficient investors to replace the individual buyers who cannot raise funds, capital values are maintained.

Question 34

34. What two circumstances will cause the demand for an asset to change?

Answer 34

• Investors’ opinions of the characteristics of the asset remain unchanged but external factors alter the demand for that asset. These external factors include investors’ cashflows, investors’ preferences and the price of other investment assets.
• Investors’ perceptions of the characteristics of the asset, principally risk and expected return, alter.

Question 35

35. Describe with the aid of an example how institutional investors’ income affects the demand for different asset classes.

Answer 35

The amount of money available for investment by institutional investors can have a significant impact on market prices. This is especially true of changes in the flow of funds into institutions with tightly specified investment objectives. For example, an open-ended fund investing in emerging markets that receives a large inflow of cash must invest it in the markets specified in their marketing literature. This can force up prices in the target markets. The good returns generated might then encourage further investment, setting off a spiral of growth.

Question 36

36. List seven factors that can affect investors’ preferences for different asset classes.

Answer 36

Investors’ preferences for a particular asset class can be altered:
* by a change in their liabilities
* by a change in the regulatory or tax regimes
* by uncertainty in the political climate
* by ‘fashion’ or sentiment altering
* by marketing
* by investor education undertaken by the suppliers of an asset class
* sometimes for no discernible reason.

Question 37

37. How are the prices of alternative investments related?

Answer 37

All investment assets are, to a greater or lesser extent, substitute goods. This is particularly so if we consider investment at the individual security level, but is also true across asset classes or across international markets. There is a strong correlation between the prices of different asset classes.

Question 38

38. How will an increase in supply affect share prices?

Answer 38

An increase in supply - eg a lot of new issues - will cause downward pressure on share prices.

Question 39

39. What controls the supply of government bonds?

Answer 39

In government bond markets the supply is largely controlled by the government’s fiscal deficit and its strategy for financing the deficit.

Question 40

40. What other factor may increase the supply of assets, particularly in derivatives markets?

Answer 40

Occasionally, supply is increased by technological innovation. It can be argued that this is the case in the derivatives markets where a greater understanding of the pricing of and reserving for complex products has allowed investment banks to supply them to end users more cheaply, thus increasing the quantity demanded.

Question 41

41. Outline two approaches the government can use to encourage companies or individuals to spend.

Answer 41

Investor preferences can be influenced by government and central bank attempts to control growth in an economy through influencing the monetary supply in the market.
One option governments have to encourage companies or individuals to spend money rather than save is to reduce interest rates.
When interest rates are close to zero, governments and central banks will consider a different approach. One approach is quantitative easing (QE). QE can lead to lower interest rates which can:
* reduce the returns on money market assets and bonds, reducing the appeal of those assets
* reduce the cost of borrowing for businesses and households. If businesses use the money to invest and consumers spend more, this can give the economy a boost.